Polishing Apple's Future

April 20, 2004

By Alex Salkever Apple (AAPL) produced another triumphal earnings report on Apr. 14, with CEO Steve Jobs beaming as he announced soaring numbers. For the second fiscal quarter of 2004, ended Mar. 27, Apple earned 12 cents per diluted share -- triple the number from the same time last year. Net profit hit $46 million, and gross revenues grew 29% from the previous quarter, to $1.91 billion.

The results showed that iPods had strong sales momentum. Apple sold 807,000 of the pint-size but superpopular digital-music players, a 10.1% increase over the previous quarter's sales. At that rate of increase, Apple could see iPod sales climb past 1 million units per quarter by early 2005.

AFTER THE CHAMPAGNE. Wall Street toasted the swell results, sending up Apple's stock to $29, from $27, on the news. Shares have since settled down to the $28 range as of Apr. 20, but that's still close to Apple's 52-week high of $29.50 -- with no signs of weakening.

After that champagne, though, investors need to sober up. That's because Jobs & Co. still has some problems it needs to attack pronto if it wants to keep all those investors happy. First of all, the country's most powerful public pension fund, the California Public Employee Retirement System (CalPERS), plans to lodge a no-confidence vote against Apple's board of directors. Second, the outfit continues to ignore shareholder pleas that it dip into its huge cash hoard and cough up a dividend.

Finally, while iPod sales looked huge, computer sales failed to grow as quickly as the overall industry expanded. All of this should be food for thought for Apple's directors as they sit down to discuss the future of this week.

WEIGHING THE OPTIONS. Take CalPERS. When a stock's large institutional shareholders refuse to approve a board slate, it's serious business. In March, it happened at Disney (DIS), after shareholders, led by CalPERS and Roy Disney, rebelled against lackluster long-term management and stock returns. They nearly forced out heretofore-omnipotent CEO and Chairman Michael Eisner and have undercut his hold on the Magic Kingdom by taking away his board title.

Apple's board faces a similarly serious problem. It has time and again irked corporate-governance advocates and big shareholders with its profligate issuance of stock options. The anti-option crowd argues that the practice essentially gives away chunks of Apple to its employees -- mostly executives -- without recording the costs to investors who actually purchased shares on the open market.

Last year, the board ignored a strong shareholder resolution requesting that Apple begin to include the cost of stock options as part of its financial results. That would attach a real bottom-line cost to the practice and could discourage options issuance, particularly if Wall Street reacts negatively to diminished earnings numbers.

GROWING PRESSURE. Apple may be mending its ways. In its Apr. 13 conference call to analysts, finance executives announced they had set aside restricted stock as executive compensation to the tune of $3.8 million per quarter over the next four years. Restricted stock shows up as an expense against Apple's income statement. While company representatives say this doesn't mean Jobs & Co. is renouncing stock options, using restricted stock instead of options is a step in the right direction.

In all likelihood, Apple will have to start expensing options anyway due to pending changes in corporate-governance standards at the Financial Accounting Standards Board, the arbiter of such matters for publicly traded U.S. companies. Microsoft (MSFT) has ceased to issue options and instead has switched its compensation to restricted stock grants that are reflected in the bottom line.

Merrill Lynch issued a statement last year underscoring its belief that the current stock-option-accounting rules should be changed. Apple would do well to pay attention -- or else its shares could lose allure with the all-important institutional investors who hold the majority of its stock. And that could diminish Jobs's ability to raise money in the future on Wall Street. CalPERS says it will still decline to approve Apple's board.

TIGHTWAD? Apple also looks increasingly dated in its attitude toward dividends. With capital-gains taxes continuing to fall and stock appreciation in a holding pattern, many shareholders are clamoring for these payouts. And Microsoft has more or less forced the rest of the tech sector to reconsider awarding dividends after it began giving them out last year.

These payouts have a real allure for investors. Dividends help to shelter them from the risk that share performance won't be up to snuff by allowing them to still show some portfolio-value growth.

Apple now sits atop $4.6 billion, with no debt. What it plans to do with this cash other than admire it remains unclear. If Apple has grand plans, great -- tell the shareholders about them. It's wise to keep a buffer against hard times, but the size of the current cash cache outstrips reasonable safety requirements. Over the long haul, as more tech outfits award dividends, Apple's shares will ultimately look less attractive if it stays in miser mode.

PERIPHERAL VISION. Finally, there's the computer-sales-growth number. Apple managed to increase it by only 5% for the quarter, year-over-year. Worldwide PC shipments in the first quarter of 2004 grew 13.4%, according to technology consultancy Gartner. That means in relative terms Apple is falling behind by growing more slowly than its rivals.

Yes, Apple's user base continues to widen. And Macheads tend to keep their machines longer than their Wintel counterparts. But the Windows PC lifecycle is stretching out well beyond two years now. And a relative loss of market share is definitely not something investors like to see. Further, claims that iPod can power Apple's long-term growth are overdone. Apple garnered five times more gross revenues from computer sales than from sales of iPods in the past quarter.

Truth is, it's hard to imagine the iPod ever becoming Apple's real revenue engine, partly because so many other parts of its revenue generation are tied to computer sales -- monitors, AirPort wireless networking stations, OS X software, the .Mac service. The sales of these peripheral products and services combined actually rival the iPod in terms of total revenues.

STEP BY STEP. So while it's great that Apple seems to be winning the digital-music race, a little perspective is in order. Mac sales really need a lift, and there's a simple way to do this: cut prices. Consumers still see Macs as the most expensive PCs around. And so far, the G5 has been a sales disappointment.

Apple needs to learn that price is determined by market demand and not its own perception of what products are worth. Its prospects look brighter now than at any point in recent memory, and it still boasts some of the fattest margins -- if not the fattest -- in the business for its PCs. Jobs & Co. has the tools to really turn Apple into a mainstream player if they can boost computers sales by dropping prices. Apple has the cash to reward shareholders with dividends. And it can easily afford to own up to stock-options expensing. It's up to the board of directors to perform the reality check necessary to shore up Apple's future. Salkever is Technology editor for BusinessWeek Online. Follow his Byte of the Apple column, only on BW Online